Chiang 2015

THE JOURNAL OF FINANCE • VOL. LXX, NO.
2 • APRIL 2015
Estimating Oil Risk Factors Using Information

from Equity and Derivatives Markets
I-HSUAN ETHAN CHIANG, W. KEENER HUGHEN, and JACOB S. SAGI∗
ABSTRACT
We introduce a novel approach to estimating latent oil risk factors and establish
their significance in pricing nonoil securities. Our model, which features four factors
with simple economic interpretations, is estimated using both derivative prices and
oil-related equity returns. The fit is excellent in and out of sample. The extracted oil
factors carry significant risk premia, and are significantly related to macroeconomic
variables as well as portfolio returns sorted on characteristics and industry. The
average nonoil portfolio exhibits a sensitivity to the oil factors amounting to a sixth
(in magnitude) of that of the oil industry itself.
FEW, IF ANY, COMMODITIES have been the focus of more attention for their per-
ceived economic significance than oil. While there is strong evidence relating
oil prices to the business cycle, the nature of the relationship is nonlinear, time-
varying, and difficult to attribute to any single source such as political uncer-
tainty, cartel decisions, or global economic conditions (see Hamilton (2003) and
Barsky and Kilian (2004)). Despite its prominence in the business media and
economics literature, and despite the well-documented role of business cycles in
asset pricing, academic research has largely failed to find consistent evidence
that oil is an important determinant of cross-sectional asset prices.1 This paper
introduces a new model and method to estimate latent oil risk factors using
∗ Ethan Chiang and Keener Hughen are from the Belk College of Business, University of North
Carolina at Charlotte. Jacob Sagi is from the Kenan-Flagler Business School, University of North
Carolina at Chapel Hill. We are grateful to seminar participants at HEC Paris, the University of
Colorado, the University of Florida, the University of Maryland, and the 25th Annual Conference
of the Financial Markets Research Center at Vanderbilt University for their useful comments.
We particularly benefited from comments by Gurdip Bakshi, Bernard Dumas, Pete Kyle, Chris
Leach, Andy Naranjo, Sugata Ray, Georgios Skoulakis, Zijun Wang, the editor (Cam Harvey) and
anonymous referees. Jun Chen provided excellent research assistance. Ethan Chiang and Keener
Hughen acknowledge the support of the Belk College Summer Research Grant. Jacob Sagi thanks
The Nickell Faculty Fund for financial support.
1 Attempts to use Fama and MacBeth (1973) type regressions to deduce oil risk premia from the
cross-section of asset prices have yielded insignificant results (e.g., Chen, Roll, and Ross (1986)).
Direct estimates of risk premia for oil factors using oil derivative price dynamics have yielded mixed
results, but even when they have come up significantly there has been no attempt to connect such
results to cross-sectional asset pricing. Confounding this, Huang, Masulis, and Stoll (1996) find
virtually no relation between futures returns and U.S. stock market returns. On the other hand,
Ferson and Harvey (1993) find that a five-factor model including oil risk performs better than a
single-factor model in predicting the returns of global equity markets. Complementing this finding,
DOI: 10.1111/jofi.12222
769
770 The Journal of FinanceR
noisy price information from both equity and derivative markets. Put simply,
we extract four distinct oil price components and find that these are important
in explaining the movement of asset prices and macroeconomic fundamentals.
While similar models and techniques have been used to explore the valuation
of commodity derivatives, we are the first to tie the methodology to the pric-
ing of equities.2 In particular, the studies that find significant risk premia in
oil-related factors (e.g., Casassus and Collin-Dufresne (2005) and Trolle and
Schwartz (2009)) have not established whether these risk premia are economi-
cally relevant outside oil derivative markets. The oil factors we extract appear
to have an economically and statistically significant relationship with macroe-
conomic variables such as real GDP, industrial production, unemployment,
inflation, and market uncertainty (the VIX). Our four oil factors explain 23.6%
of the variance of oil industry returns beyond what can be explained using mar-
ket returns alone, and this oil risk exposure is associated with a risk premium
of 5.3%. The magnitude of oil risk exposure exhibited by nonoil characteristic
and industry portfolios is on average about a sixth of that of the oil industry,
and compensated by a commensurate risk premium. Overall, our work can be
seen as a new approach to Ross’s (1976) Arbitrage Pricing Theory (APT) em-
ploying structural models together with data from several linked markets to
extract a less noisy set of fundamental and systematic pricing factors.
In our econometric specification, the log-price of oil is affected by four distinct
components. One can be thought of as transient while another may be viewed as
persistent. The drift in the persistent component is itself a factor, reflecting the
long-run trend in oil prices. Finally, the fourth component drives the stochastic
volatility of oil prices (known to exhibit heteroskedasticity). Thus, each of our
model’s components has a ready interpretation in terms of fundamental news
affecting oil prices, which is potentially important in sorting out how oil shocks
impact the macroeconomy (see Hamilton (2003) and Barsky and Kilian (2004)).
We estimate the model using oil futures prices and option-implied variance,
augmented with returns on oil-related stocks. The latter can be an important
source of information about oil prices that may not be captured by short-dated
derivatives. The model is estimated using 30 years of daily data on futures,
options, and equity returns, fitting derivative prices and returns very well
both in and out of sample. The latent factors identified by our estimation
methodology carry significant risk premia, both statistically and economically,
with magnitudes of unconditional annual Sharpe ratios as high as 0.43. Of the
Backus and Crucini (2000) observe that oil shocks are important determinants of relative price
movements in international markets.
2 Related derivative pricing models include Casassus and Collin-Dufresne (2005), Gibson and
Schwartz (1990), Hughen (2010), Schwartz (1997), Schwartz and Smith (2000), and Trolle and
Schwartz (2009). Recent studies linking oil prices and price volatility to oil equities include
Elyasiani, Mansur, and Odusami (2011), Oberndorfer (2009), and Ramos and Veiga (2011). Our
more structural approach to extracting the factors allows us to obtain a better fit to oil equity
prices over a longer horizon, simultaneously fit to oil derivative prices, uncover the risk premia
associated with the oil factors, link oil factors to the macroeconomy, and demonstrate the factors’
relationship with the broader cross-section of equities.
Estimating Oil Risk Factors from Equity and Derivatives Markets 771
four, the oil volatility factor appears to be the most related to nonoil variables,
including the macroeconomic variables mentioned earlier as well as the Fama-
French (2003) factors.
The paper makes several contributions to the literature. First, we demon-
strate that stock prices contain important information about fundamentals,
such as commodity prices, that is not contained in commodity derivatives.
By combining information from both markets, we explain oil-related security
prices and returns better than traditional asset pricing approaches. Second,
our model and the estimation methodology are important to the real options
literature, where valuation relies disproportionately on an accurate descrip-
tion of persistent dynamics and stochastic volatility. Third, we demonstrate
that oil shocks are systematic and command nontrivial prices of risk. Finally,
among the types of news about oil, our approach identifies shocks affecting the
magnitude of uncertainty in oil prices as most important to the macroeconomy
and cross-section of expected returns.
We do not presume that oil (combined with the market) spans all pricing
factors. The paper seeks to provide insights to anyone who believes that oil
plays an important role in the pricing of securities—regardless of whether one
is motivated by ad hoc or general equilibrium considerations to include oil in an
empirical asset pricing model. Our study suggests that stochastic oil volatility
is as important, if not more so, for the macroeconomy than oil price itself.
The study also suggests that permanent and temporary oil price shocks have
different effects on asset prices. In that sense, the paper is best viewed as a
thorough attempt to study how oil risks are linked to oil and nonoil securities
rather than as a prespecified factor model like that of Chen, Roll, and Ross
(1986). Our approach and findings complement recent work that explicitly
models the role of oil in the pricing of securities (see Baker and Routledge
(2012) and Ready (2012, 2013)).
The paper is structured as follows. Section I introduces our four-factor model,
describing its dynamics, derivative prices, and the link between equity returns
and the model risk factors. Section II describes the data we employ and the esti-
mation methodology (Markov chain Monte Carlo, MCMC). Section III presents
the estimation results and the cross-sectional analysis of the extracted latent
factors. Section IV concludes. Appendices A to D contain details of the model
derivation and estimation procedure. A supplementary Internet Appendix con-
tains further information.3
I. Model
Our goal is to estimate oil-relevant state variables from observed prices of
oil futures, options, and equities. To do so efficiently, we look for a specification
admitting closed-form solutions for futures and option prices in terms of fun-
damental state variables. Following the literature on term structure modeling
for interest rates and commodities, we opt for an affine specification (see, e.g.,
3 The Internet Appendix may be found in the online version of this article.
the references in Collin-Dufresne, Goldstein, and Jones (2009)). Intuitively, one

should be able to distinguish three types of factors that influence oil prices and
their forecasts: a transient factor, a growth trend (i.e., long-run forecast) factor,
and a permanent shock factor. All three factors should be reflected in futures
prices through the near-term slope, long-term slope, and level of the term struc-
ture. Moreover, Trolle and Schwartz (2009) and Hughen (2010) demonstrate the
presence of a fourth factor, not spanned by futures prices, that impacts volatil-
ity. Thus, a minimal realistic description suggests the use of a four-factor affine
model given by the following risk-neutral Itô diffusion:

dXt = A∗ + B∗ Xt dt + t dW ∗ ,
where Xt is a four-dimensional state variable and t t is affine in Xt . In

Appendix A we derive the parametrizations of the coefficient matrices A∗ , B∗ ,
and t t implied by the presence of a persistent component, a single and un-
spanned volatility component, and identifiability. The spot price of oil evolves
according to log St = Xs,t + Xp,t , and, as we discuss shortly, the vector of oil fac-
tors, Xt = (Xs,t , Xl,t , Xp,t , Xv,t ) corresponds to the transient (short-term), growth
trend (long-term), persistent, and unspanned volatility factors, respectively.
Following standard practice, the dynamics of Xt under the physical measure
are also assumed to have an affine drift of the form A + BXt . The first three
elements in the fourth row of the matrix B must be zero if the instantaneous
variance is to be positive definite under the physical measure. The instanta-
neous risk premium associated with the oil factors is the difference between
the physical and risk-neutral drifts,
t = A − A∗ + (B − B∗ )Xt . (1)
Constraining the risk premium to be stationary restricts the third column

(corresponding to the persistent variable Xp,t ) of the matrix B to be zero.4
We note that the risk premium is dynamic, consistent with recent general
equilibrium models of oil price risk.5
A. Futures
The futures price Ft,τ at time t for delivery at time t + τ of one unit of oil is
derived in Appendix B and given by
Ft,τ = eχ(τ )+ηs (τ )Xs,t +ηl (τ )Xl,t +η p(τ )Xp,t , (2)
4 Similar assumptions about the relation between the risk-adjusted and true drifts are made in
Cheridito, Filipovic, and Kimmel (2007), Collin-Dufresne, Goldstein, and Jones (2009), and Hughen
(2010). A dynamic risk premium for oil is consistent with general equilibrium.
5 In Baker and Routledge (2012), the dynamics are a function of risk-sharing among agents
while in Ready (2012) they result from supply fluctuations. Our decomposition better resembles
the supply interpretation in Ready (2012), where long-run, short-run, and volatility fluctuations
in supply can be priced differently in equilibrium. Ready (2013) provides evidence complementary
to ours for the importance of oil supply shocks in the cross-section of returns.
where ηs (τ ) declines with maturity, ηl (τ ) increases with maturity, and η p(τ ) is

constant. Because ηs declines with maturity, an increase in Xs,t will increase
the short end of the log-futures curve but will have little effect on the long end.
Intuitively, a shock to Xs,t may correspond to changes in oil prices that quickly
induce high-cost producers to enter or exit the market, or cause consumers to
switch to readily available energy alternatives. By contrast, an increase in Xl,t
will have little effect on the short end but will increase the long end, reflecting
news about the long-run trend to which producers and consumers cannot (or
need not) readily adjust. Finally, an increase in Xp,t will shift the entire log-
futures curve upward by the same amount across all maturities, representing
a permanent shock, consistent with the fact that oil is an exhaustible resource
and is sensitive to technological shocks. This confirms the postulated roles of
the three risk factors and allows us to identify them with different types of
economic news concerning oil prices. Note that, by definition, futures prices do
not explicitly depend on the unspanned volatility state variable, Xv,t .
Much of the literature on commodity derivative prices focuses on explicitly
modeling the net convenience yield, which represents the benefits forgone by
those who have forward rather than current rights to the use of a commodity. In
an Itô diffusion setting, the instantaneous net convenience yield, δt , is defined
by the risk-neutral evolution
dSt
= (r f ,t − δt ) dt + t dW ∗ ,
St
where r f ,t is the prevailing instantaneous risk-free rate. In our setting, one can
write the convenience yield as
δt = r f ,t + κs Xs,t − Xl,t ,
where κs is the speed of mean reversion of Xs,t . To interpret this equation,

consider that a temporary increase in oil price (i.e., increase in Xs,t ) benefits
those who have oil in inventory more than those who have future claims to oil.
The more transient the shock (i.e., the larger is κs ), the greater is the relative
benefit to inventory owners. Similarly, an increase in the future price of oil
(i.e., Xl,t ) benefits forward claim holders more than inventory holders because
the latter have to pay storage costs to cash in on the higher future price of
oil. Finally, if interest rates are high while oil prices are expected to remain
constant, anyone in current possession of oil can sell it and earn a high interest
rate on the proceeds, only to buy the oil back in the future if and when it is
needed.
B. Options
The Chicago Mercantile Exchange (CME) lists options on crude oil futures
contracts from which one can hope to extract information about the unspanned
volatility state variable, Xv,t . Calculating model option prices and fitting them
to observed prices using MCMC would be too computationally intensive.
Instead, we follow the literature on model-free implied variance, on which

indexes such as the VIX and the newly disseminated OVX are based, and cal-
culate a nonparametric measure of implied variance from CME oil options.
Define IVt,T to be the implied variance of an asset between dates t and T > t.
Specifically, IVt,T is the risk-neutral expected value of the instantaneous return
variance of the asset, averaged over the period between t and T . Britten-Jones
and Neuberger (2000) and Jiang and Tian (2005) demonstrate that, for a large
class of diffusion processes, if the risk-free rate is not correlated with futures
prices, then6
2
T
dF −s
(T − t) × IVt,T = Et∗
s,T
t Fs,T −s
∞
Ct (T − t, K)e yt,T −t (T −t) − (Ft,T −t − K)+
=2 dK, (3)
0 K2
where Ct (τ, K) is the date t price of a European call option with strike price
K and maturity τ and yt,τ is the time t yield of a risk-free discount bond with
maturity τ . The integral above can be constructed directly from option prices,
and thus the implied variance, IVt,T , is essentially observed (albeit, with error).
In Appendix C, we show that the affine structure of our model leads to a linear
expression of implied variance in Xv,t :
IVt,T = γ (t, T ) + δ(t, T )Xv,t . (4)
Thus, the information content about Xv,t in option prices can be extracted very
efficiently.
C. Equities
The value of a firm is the present value of all short- and long-term projects.
Thus, the stock prices of firms with high exposure to the oil risk factors should
reflect information about both the long- and short-horizon state variables. Un-
like the case of futures and options, we do not have a structural model of how
stock prices depend on oil prices. Instead, we rely on a simple model that is
consistent with Merton’s (1973) intertemporal CAPM, the general equilibrium
model of Cox, Ingersoll, and Ross (1985), and other continuous-time versions
of Ross’s (1976) APT, where instantaneous stock returns are linear in the un-
derlying state variables. To this end, recall that t from equation (1) is the
instantaneous risk premium of Xt . The absence of arbitrage requires that a
portfolio whose instantaneous returns are perfectly correlated with Xi,t must
have instantaneous expected excess returns of i,t . If our model were perfectly
specified and we observed futures and options prices without error, then we
6 If the horizon T − t is short, then nonzero correlations of futures prices with interest rates will
have a negligible impact. This is the case with the horizon of implied variance data we consider.
could construct such “factor-mimicking” portfolios and their instantaneous ex-

cess returns would be given by

dXte = dXt − Et [dXt ] + t dt = t dWt + t dt. (5)
Our simple model for oil stock prices assumes that the returns on a portfolio
of oil stocks will depend only on the market returns, the oil factor-mimicking
portfolios, and nonsystematic risk.7 Specifically, let dP Pt
t
− r f ,t dt be the instanta-
neous returns of an oil stock portfolio in excess of the risk-free rate, r f ,t , and let
dMt
Mt
− r f ,t dt be the instantaneous excess returns on the market portfolio. Then
we model oil equity returns as

dPt dMt
− r f ,t dt = bM − r f ,t dt + boil dXte + dzt , (6)
Pt Mt

where dzt is independent of dMt and dXte . The vector boil = (bs , bl , bp, bv ) rep-
resents the oil factor sensitivities net of the effects of the market portfolio.
In practice, one expects that the factor sensitivities bM and boil will be time-
varying. Absent a strong prior on the time-variation of these coefficients, we
set them to be constants. This reduces our ability to extract information about
the oil factors from stocks and constitutes a more conservative approach to the
null hypothesis that stocks do not contain additional information about oil risk
factors beyond the information contained in futures.
D. Discretized Model
Data are observed only at discrete times and the transition density of the
state vector must be computed over the length of time between observations.
Because of the stochastic volatility, the transition density for our model is not
known in closed form; however, it can always be approximated by a Gaussian
density by applying an Euler discretization. Although this approximation does
introduce some error in the computed transition density, previous studies show
that the error is typically very small for observation frequencies less than
roughly one week. We use daily observations in our empirical investigation
and thus the error should be small. We also assume that the observed futures
and option prices are measured with white noise error, ξt and et , respectively.
The complete discretized model that we estimate, written in state-space form,
is
√
Xt+t = At + (I + Bt)Xt + tt εt+t , (7)

log Ft,τ = χ (τ ) + ηi (τ )Xi,t + ξt,τ , (8)
i=s,l, p
7 The return on aggregate wealth, for which the market is a proxy, appears in most equilibrium
asset pricing models. Similarly, Chen, Roll, and Ross (1986), Al-Mudhaf and Goodwin (1993),
Sadorsky (2001), and Scholtens and Wang (2008), among others, also include a market factor,
along with proxies for oil risk factors, in their asset pricing models.
IVt,T = γ (t, T ) + δ(t, T )Xv,t + et,T , (9)

e
rz,t+t = bz,M ReM,t+t + e
bz,i Ri,t+t + z,t+t , (10)
i=s,l, p,v
where εt , ξt , et , and t are normal i.i.d.; the coefficient matrices are functions
e
of the parameters and contract maturities; rz,t+t and ReM,t+t denote excess
returns on the equity portfolios indexed by z and on the market, respectively;
e
and Ri,t+t is the i th component of Xt+t − Xt − A∗ t − B∗ tXt , which is the
discrete-time version of the excess return on the factors in equation (5).
II. Data and Empirical Methodology

The data consist of daily prices of crude oil (WTI) futures contracts as re-
ported on the NYMEX, option contracts on WTI futures obtained from the
CME, and daily returns of portfolios of oil-related firms. The sample period
is March 30, 1983, when crude oil futures first began trading, to December
31, 2012. As discussed in Trolle and Schwartz (2009), the more liquid futures
are the nearest six or seven contracts and those with delivery in December
for up to about four years out. The last day to trade a particular contract is
the third business day prior to the 25th (or the last business day preceding
the 25th if the 25th is not a business day) of the month prior to the delivery
month. Because the vast majority of contracts are closed out prior to delivery,
the open interest declines sharply during the final two weeks of the contract’s
life. Accordingly, we discard the nearby contracts from the data sample, and
use the next six monthly contracts and the next three December contracts in
the estimation. The total number of daily observed futures prices in the sample
is 59,836 and the maturities of the contracts used in the sample range from
about nine weeks to four and a half years.8 Daily volume and open interest
for the shortest maturity series we use average 56,297 and 104,480 contracts,
respectively.
Crude oil options on WTI futures began trading in November 1986, with each
option expiring three business days prior to the last day to trade the underlying
futures. Options trade far less actively than futures: in our sample, options with
maturities between 15 and 60 days averaged a daily volume and open interest
of 614 and 3,985 contracts, respectively. We drop options with maturity of 14 or
fewer days because their price data are less reliable (there is significantly less
interest in the underlying contract). Using the remaining contracts, we con-
struct the implied variance index in equation (3) with the nearest-to-maturity
8 The actual time to maturity for an oil futures contract is not precisely determined, because
delivery may occur any time during the delivery month at the short side’s discretion. Following
common practice, we assume that delivery occurs at the end of the delivery month. This is because
oil is typically in backwardation, implying that the benefit of ownership exceeds the risk-free rate,
making it advantageous to hold onto the asset for as long as possible. Thus, we assume that the
maturity date is the final business day of the delivery month.
out-of-the-money contracts.9 Details of the index construction are available in

the Internet Appendix.
We use four equity portfolios in the estimation of equations (7) to (10) con-
structed from the returns on oil-related stocks. Specifically, each year we form
quintiles of size-sorted stocks with SIC classification 1311, 1381, 1389, 2911,
or 5172. We then value-weight all stocks in the top quintile to form one portfo-
lio, and repeat for the bottom quintile. We similarly construct top and bottom
quintile portfolios based on the book-to-market ratio.
To investigate the systematic nature of our factors, we obtain from Kenneth
French’s online data library returns on 49 industry portfolios, the 25 size and
book-to-market portfolios, the 25 size and momentum portfolios, the Fama-
French-Carhart (FFC; see Fama and French (1993) and Carhart (1997)) factors,
and the risk-free rate.
We employ MCMC to estimate the model in equations (7) to (10). Appendix
D describes our procedure in greater detail. To assess the impact of using in-
formation from the equity market, we first estimate the model using only the
futures and options data. We then repeat the estimation procedure including
information from equity returns. For each estimation, a Markov chain of length
200,000 is generated, discarding the first 100,000 draws in the MCMC simu-
lation to negate the effects of initial conditions. From the remaining draws,
only 1 out of every 10 is saved to improve the independence of each simulated
instance, leaving 10,000 draws from the posterior distribution.
III. Results and Empirical Analysis

Our analysis is divided into three parts. The first part reports key results
from the estimation and goodness of fit. By comparing model estimates with
and without equity returns, we establish that equity returns contain informa-
tion about the oil risk factors that is not contained in oil futures and options.
We find that, along with the market returns, the four oil factors explain a
substantial amount of the variation in oil-related equity portfolios, especially
when compared with traditional methods of accounting for systematic risk. We
then establish that the model is robust by assessing out-of-sample goodness of
fit. The second part considers the implications of the model for oil risk and re-
turn. Oil risk appears to be priced, and hence systematic. Moreover, the model
is instrumental in deriving estimates of oil risk premia, net of the market
equity premium. The third part assesses the relevance of the model beyond
oil derivatives and equities by examining the relationship of the imputed oil
factors with macroeconomic variables and nonoil stocks. We find that oil risk
is significantly related to current and future stock market volatility, changes
9 In principle, one can construct several implied variance indexes corresponding to different
average maturities and use all of them in the estimation. In experimenting with this approach,
we found that the term structure of oil-implied variance requires more than the single factor Xv,t
employed in our model. Instead of expanding the model and incorporating more degrees of freedom,
we opted to keep the model structure the same and fit to a single implied variance series. The nearby
series we employ has roughly twice the open interest and trading volume as the second-nearby.
Table I
Goodness of Fit
The mean daily root mean square errors (RMSEs) for log-futures prices are reported in basis
points, the RMSEs for implied variances are reported in percentages, and the R2 ’s for the four
portfolio returns are reported in percentages. The column labeled “Derivatives Only” reports the
results using the procedure in which the model parameters and latent variables are estimated
using futures and implied variance data and then the factor loadings are estimated from equity
returns. The column labeled “Full Information” reports the results estimated using futures, implied
variances, and returns simultaneously. For comparison, the resulting R2 ’s for the Fama-French-
Carhart (FFC) model are also reported.
Derivatives Only Full Information FFC
Futures RMSE (basis points) 27.4 28.3 –

ImpVar RMSE (percentage) 0.8 1.7 –
Futures R2 (percentage) 100.0 100.0 –
ImpVar R2 (percentage) 99.80 98.1 –
R2 (percentage)
Small Oil Stocks 43.8 71.4 50.3
Large Oil Stocks 55.0 72.6 50.0
Low B/M Oil Stocks 52.5 80.3 47.7
High B/M Oil Stocks 53.8 77.1 53.7
Average R2 51.3 75.3 50.4
in the rate of inflation, industrial production growth, changes in percentage

unemployment, and GDP growth. This supports the view that extracted risk
factors are systematic and have economy-wide influence. Furthermore, we find
that the magnitude of exposure of nonoil stock portfolios to oil risk is, on aver-
age, a sixth of that of the oil industry, with industries connected to commodities
or manufacturing exhibiting the highest sensitivity.
A. Estimation
A.1. Goodness of Fit
Table I reports the fit to the data based on the parameter estimates and
filtered state variables. We refer to an estimate of the parameters and latent
variables as “derivatives-only” when the data consist only of the futures and
implied variance series. We refer to the estimate as “full-information” (FI) when
equity returns are also included in the estimation. The parameter estimates
are reported in the Internet Appendix. For the futures, the pricing error is
given by the difference between the fitted log-prices and actual log-prices. Fol-
lowing Trolle and Schwartz (2009), on each day we calculate the root mean
squared error (RMSE) for the futures contracts in the estimation, which is the
square root of the average squared errors across all futures contracts on that
day. The table reports the average of these daily RMSEs. We also calculate an
unadjusted R2 for all 67,545 futures price predictions. Both derivatives-only
and FI estimates deliver excellent fits to the futures data. In both cases the
RMSE is roughly 0.28% and the R2 is essentially one. For comparison, Cortazar
and Naranjo (2006) report an RMSE of 0.51% for their Gaussian three-factor
model, Hughen (2010) reports an RMSE of 0.44% for his maximal A1 (3) model,
and Trolle and Schwartz (2009) report an RMSE of 0.39% for the most general
specification of their model; although these studies use different futures data
than we do, the results suggest that misspecification error is not a major con-
cern in our formulation. While the fit is excellent, the RMSE is still about 10
times higher than recent bid-ask spreads on the most liquid contracts.
We also calculate the R2 and RMSE for the implied variance. The RMSE is
calculated as the square root of the time series average of squared errors and
as such understates the goodness of fit relative to the method used by Trolle
and Schwartz (2009).10 While the fit is good (with an R2 of more than 98%
with or without the equity data), it is not as precise as the fit to the futures.
On the other hand, the RMSE is roughly of the order of magnitude of the bid-
ask spread on the associated portfolio of options.11 We conclude that, given
the limitations of the data and the model, the fit to both derivative prices is
excellent.
The most important difference between estimating the model with versus
without the equity data is seen in the fit to equity returns. The proportion
of variance explained by the model for each of the four equity return series
is documented in Table I for both estimation approaches as well as the FFC
model. Using only derivative prices to estimate the parameters yields results
that are on par with the standard FFC model, with an R2 of about 50%. Indeed,
much of the explanatory power in both instances comes from the market compo-
nent, ReM,t , which on average explains 40% of the variance. By contrast, the FI
estimation procedure yields a substantial improvement in explanatory power,
averaging 75.3% of the variation across the four portfolios. This provides strong
evidence that the model is picking up relevant risk factors. The improvement
in R2 is largely driven by improved marginal R2 ’s in the short-term factor Xs,t
and the volatility factor Xv,t (and shared equally between them). We argue later
that this may be because both depend on high-frequency information contained
in equity returns.
Figure 1 plots a time series of the model-estimated factors using FI esti-
mates. The estimation produces a posterior distribution for the value of each
factor on each date and the corresponding figure depicts the mean of that dis-
tribution. Note that the plot for the volatility factor, Xv,t , is hard to distinguish
from observed implied variance over the sample period in which options are
available to construct implied variance. Both the transient and strictly long-
term oil risk components exhibit similar cyclical behavior. This is important
and suggests that the model is capable of disentangling a single shock into dis-
tinct short- and long-term components. The third, persistent, component has
10 To best compare with Trolle and Schwartz (2009), we would have to calculate the average
absolute error for implied variance. Doing so yields a goodness of fit that is comparable to theirs.
11 Using two ticks, or $0.02, for the bid-ask spread on WTI options, a conservative estimate for

∞
the bid-ask spread on the implied variance portfolio is 2 1τ Ft,τ $0.02
K2
dK = 2 $0.02
τ Ft,τ , which averages
over the sample period to roughly 1% (although it would be half as much for recent data).
Figure 1. Estimated oil factors and option implied variance. This figure depicts time series
of estimated latent oil risk factors at the mean of their posterior distributions: the transient
component, Xs,t (top panel); the long-term component, Xl,t (second panel); the persistent component,
Xp,t (third panel); and unspanned volatility Xv,t (bottom panel, in black and plotted together with
option-implied variance in gray).
clearly experienced a secular increase since roughly 2002. This too is intuitive
and predicts that the high price of oil experienced over the past 10 years is
likely to remain high in the foreseeable future. Finally, the volatility compo-
nent appears to experience acute periods of high volatility, reflecting events
causing great uncertainty in energy markets. Most notable among these are
the collapse of the OPEC agreements and subsequent OPEC price wars in late
1985 and early 1986, the First Gulf War between late 1990 and early 1991, the
Second Gulf War in March 2003, and the Global Financial Crisis of late 2008
until early 2009. In addition, Xv,t experienced a high regime between 1999 and
2002 and has since stabilized, albeit at a higher level than in the 1990s. It is
worth noting that the correlation between Xv,t and the GARCH(1,1) volatility
estimate for next-to-nearby futures returns is 0.652 while the correlation be-
tween Xv,t and historical volatility is 0.696. Given that the correlation between
the GARCH(1,1) volatility and historical volatility is a mere 0.463, we conclude
that Xv,t adequately captures stochastic volatility in our estimation approach.
A.2. Model Stability

To test the robustness of the estimation methodology, we divide the sample
period into three parts: early (March 30, 1983, to December 31, 1993), middle
(January 3, 1994, to December 31, 2003), and late (January 2, 2004, to Decem-
ber 31, 2012). Panel A of Table II presents the fitting statistics by subperiod for
the FI estimates. The results suggest a high degree of fitting consistency for the
pricing of derivatives across subsamples. The results for equity returns suggest
that the assumption of constant factor loadings does not hold in practice.
We next estimate the model (using derivatives and equity returns) restrict-
ing the data to one of the three subsamples and, fixing the resulting parame-
ters, estimating the latent variables in the other two subsamples. Panel B in
Table II reports the results in three subtables, corresponding to the subperiod
used for the parameter estimates (in each subtable, “OOS” corresponds to an
out-of-sample measure of fit). The results confirm the model’s stability for the
pricing of derivatives. The fit to equity returns, on the other hand, appears to
exhibit some deterioration in goodness of fit, also consistent with the conclu-
sion that the factor loadings are not constant. Overall, estimating the model
parameters using the late subsample appears to lead to the smallest amount of
deterioration relative to in-sample estimates. Although the out-of-sample fit to
equity returns declines when the early or middle period is used for estimating
the parameters, we note that the resulting R2 ’s are nonetheless substantially
better than those from FFC regressions (the difference in R2 is consistently
about 20%).
B. Oil Risk and Return

Equation (5) characterizes the instantaneous excess returns for a portfolio
that is perfectly correlated with the oil factors. In discrete time, we denote these
excess returns as Ri,te
with i = s, l, p, v. As mentioned following equation (10),
Table II
Subperiod and Out-of-Sample Results
Panel A reports the goodness of fit in subperiods when the model parameters and latent variables
are estimated using futures, option-implied variance, and equities from the full sample. The fit to
the Fama-French-Carhart model is also reported for comparison. Panel B reports in-sample (IS)
and out-of-sample (OOS) goodness of fit in subperiods when the model parameters are estimated
using data on futures, options, and equities from only one of the subperiods (IS). Average daily
root mean square errors (RMSEs) for log-futures prices are reported in basis points, RMSEs for
implied variances are reported in percentages, and R2 ’s for returns are reported in percentages.
Panel A: Subperiod Results
Model Full Information Fama-French-Carhart
Subsample 83-94 94-04 04-13 83-94 94-04 04-13

Futures RMSE (bps) 27.2 32.2 26.1 – – –
ImpVar RMSE (%) 1.8 1.5 2.0 – – –
R2 (%)
Small Oil Stocks 41.9 49.2 85.2 22.1 31.1 65.2
Large Oil Stocks 62.9 53.0 85.1 54.5 24.4 68.3
Low B/M Oil Stocks 60.4 62.3 90.8 38.2 24.8 64.2
High B/M Oil Stocks 54.8 56.6 89.4 40.6 37.2 66.8
Average 55.0 55.3 87.6 38.8 29.4 66.1
Panel B: Out-of-Sample Results
1983 to 1994 1994 to 2004 2004 to 2013
83–94 94–04 04–13 83–94 94–04 04–13 83–94 94–04 04–13

(IS) (OOS) (OOS) (OOS) (IS) (OOS) (OOS) (OOS) (IS)
Futures RMSE (bps) 27.8 32.0 28.3 30.2 32.6 28.5 29.1 33.1 28.0
ImpVar RMSE (%) 1.5 1.4 1.7 1.7 1.5 1.9 1.6 1.5 1.8
R2 (%)
Small Oil Stocks 33.1 48.9 67.3 27.5 50.8 70.7 30.8 47.2 84.6
Large Oil Stocks 63.5 42.7 83.3 48.9 66.1 86.1 63.9 62.5 87.8
Low B/M Oil Stocks 53.8 56.7 76.3 37.6 71.6 90.5 53.8 66.9 91.4
High B/M Oil Stocks 49.4 53.2 76.2 41.1 60.4 86.6 49.2 57.5 89.6
Average 50.0 50.4 75.8 38.8 62.2 83.5 49.4 58.5 88.4
e
Ri,t+t is the i th component of Xt+t − Xt − A∗ t − B∗ tXt and can therefore be
explicitly calculated from our estimation of the model parameters and latent
e
factors. Panel A of Table III reports time series statistics of the daily Ri,t ’s
estimated with FI. Only the sample mean (i.e., sample risk premium) of Rep,t
is significantly different from zero. This is because, for the size of our sample
period, a series of excess returns must have an annualized in-sample Sharpe
ratio of at least 36% to yield a significant sample mean of excess returns at the
5% confidence level. Only the persistent oil risk factor is associated with an
in-sample Sharpe ratio that is greater than 36%.12 Thus, the relatively short
12 The in-sample Sharpe ratio is obtained by taking the ratio of the daily sample mean and stan-
dard deviation of Rie and multiplying by the square root of 252. To help place this into perspective,
Table III
Risk and Return for the Oil Factors and Equity Portfolios
Both panels report statistics based on the full-sample estimates using futures, implied variance,
and equity returns. Panel A reports time series statistics for excess returns on oil factor-mimicking
e
portfolios, Ri,t , defined as the i th component of Xt+t = Xt+t − Xt − A∗ t − B∗ tXt . The first and
third factors correspond to the transient and persistent components in oil prices. The second factor
corresponds to the long-run trend in oil prices, and the last factor corresponds to the stochastic
volatility of oil prices. Panel B reports model estimates of the coefficients from the factor decompo-

sition of returns given by Rte = bM ReM,t + i=s,l, p,v bi Ri,t
e
+ t . The contribution of oil risk factors to
the portfolio’s risk premium is reported in the last column (“Net Oil RP”). Means and confidence
intervals for the net oil risk premia are calculated using the posterior distribution of oil risk premia
estimated from the model. “* ” (“** ”) indicates significance at the 5% (1%) level.
Panel A: Statistics of Excess Returns on Oil Factor-Mimicking Portfolios

e e
Statistic Rs,t Rl,t Rep,t e
Rv,t
Sample Mean (%) 0.001 0.004 0.058 −0.016

Sample Standard Deviation (%) 1.10 2.05 2.05 1.89
Annualized sample Sharpe Ratio (%) 1.26 2.95 44.71 −13.60
Sample 5th percentile (%) −1.68 −3.12 −3.11 −2.15
Sample 95th percentile (%) 1.66 3.17 3.13 2.32
Model Implied Unconditional:
Risk premium (annualized, %) 0.58 0.04 18.33∗ −8.40∗
Sharpe Ratio (annualized, %) 2.57 0.80 43.34∗ −39.85∗
Panel B: β’s and Net Oil Risk Premia
Asset bM bs bl bp bv Net Oil RP (%)
Small Oil Stocks 0.72∗∗ 0.67∗∗ 0.10∗∗ 0.15∗∗ −0.33∗∗ 6.02*

Large Oil Stocks 0.76∗∗ 0.51∗∗ 0.08∗∗ 0.18∗∗ −0.25∗∗ 5.85*
Low B/M Oil Stocks 0.83∗∗ 0.73∗∗ 0.09∗∗ 0.19∗∗ −0.37∗∗ 7.20*
High B/M Oil Stocks 0.80∗∗ 0.58∗∗ 0.08∗∗ 0.16∗∗ −0.32∗∗ 6.10*
time series restricts one’s ability to directly measure small but economically
meaningful levels of risk premia. Fortunately, we can calculate the risk premia
from the model parameters as follows. Equation (1) identifies the conditional
risk premium in terms of the estimated model parameters and latent factors.
Correspondingly, the unconditional risk premium is given by the four-element
vector.
¯ ≡ A − A∗ + (B − B∗ ) X̄,

where X̄ is the unconditional mean of Xt (under the physical measure) and is a
function of the estimated model parameters only. More importantly, the MCMC
estimation delivers a posterior distribution for ,
¯ thus allowing us to formally
perform significance tests. This is akin to a Fama-MacBeth (1973) regression
where risk premia are also estimated indirectly. In the latter case, sufficient
the FFC portfolios (market excess return, SMB, HML, and UMD) over the same period yielded
annualized in-sample Sharpe ratios of 41%, −2%, 46%, and 54%, respectively.
cross-sectional variation in the expected returns of the basis assets is required

to achieve statistical significance for risk premia associated with factors that
do not have high in-sample Sharpe ratios. In our case, the cross-sectional vari-
ation is provided by the different types of assets incorporated into the estima-
tion methodology (i.e., futures, options, and stocks). The next-to-bottom row in
Panel A of Table III documents the mean of the posterior distributions for the
four elements of . ¯ Both the persistent and the volatility risk factors are asso-
ciated with economically and highly statistically significant risk premia. The
corresponding model-implied unconditional Sharpe ratios are documented in
the last row and are likewise large for the persistent and volatility risk factors.
The sample Sharpe ratios are well within statistical tolerance of their model-
implied values. It is important to mention that, when only derivative prices
are used in the estimation, the model-implied risk premium and Sharpe ratio
for the volatility factor is not significantly different from zero, meaning that
the inclusion of equities is critical in estimating risk premia more accurately.
Overall, the evidence suggests that oil risk is priced and therefore systematic.
Panel B of Table III reports the means of the posterior distribution for bM
and the bi ’s for i = s, l, p, v, that is, the factor loadings of the return series on
e
the market portfolio and on the Ri,t ’s (see equation (10)). The coefficients on
the market and oil risk factors are highly significant and share similar signs
across all portfolios. There appears to be little question that all of these factors
are important in explaining the returns of the oil equity time series, although
the cross-sectional variation across the loadings is modest. The contribution of
the oil factors to the risk premia of the equity portfolios is roughly 6% to 7%
per annum (calculated using the posterior distribution of ). ¯
The positive sensitivity of oil stocks to the short-term, long-term, and per-
sistent factors is intuitive. Less intuitive, however, is the sensitivity to the
volatility factor. After controlling for the determinants of future oil value (i.e.,
Xs,t , Xl,t , and Xp,t ), one might expect that the real options possessed by oil-
producing firms would lead to a positive loading on volatility, much in the
same way that growth options might exhibit positive vega. Instead, we find
the opposite, suggesting that oil price volatility affects the value of oil-related
firms in a nontrivial manner, or that our estimation methodology is forcing
Xv,t to reflect something systematic other than oil volatility. As mentioned ear-
lier, GARCH(1,1) and historical volatility estimates of the nearby log-futures
price are less correlated with each other than they are with Xv,t . This suggests
that, as an estimate of oil price volatility, Xv,t is as good as (or better than)
GARCH(1,1) and historical volatility. Moreover, the correlation with implied
variance is extremely high and the RMSE is of the order of the bid-ask spread
for an implied variance portfolio. Thus, if Xv,t is spuriously related to some
systematic factor other than oil volatility, we are not able to identify what this
systematic factor might be.13 On the other hand, competition among interna-
tional oil companies may be sufficient to diminish the positive effects of real
13 The negative b ’s are largely robust to changing the priors in the MCMC estimation and to
v
the inclusion of longer-maturity implied variance series (and/or more equity series). Even when
options (e.g., Grenadier (2002)), leaving mostly the impact that volatility would
have in the absence of real options.14 In the next subsection we establish that
e
Rv,t is negatively related to indicators of economic growth and positively related
to the VIX index. We speculate that this, together with competition in the oil
industry, is sufficient to overwhelm any real-option effects. In other words, if a
positive shock to Xv,t is sufficiently bad for the entire economy, it is also bad for
the oil industry.
C. Oil Risk beyond the Oil Industry

The previous section demonstrates that the extracted oil factors explain oil-
sensitive securities well. Such a link between the price of a product and stocks
in its industry could be true within any industry, and perhaps is not surprising.
Two of our factors, Xp,t and Xv,t , carry economically significant risk premia and
according to the APT must represent systematic risk. This, if true, should have
ramifications outside the oil industry, which we investigate in this subsection.
To do so, we first show that there is an empirically meaningful relationship
between the oil volatility risk factor and macroeconomic variables. We then
quantify the amount of systematic oil risk, and implied risk premium, to which
nonoil portfolios are exposed (both industry portfolios and portfolios sorted
on characteristics). Overall, we find that, on average, nonoil companies are
exposed to roughly a sixth of the magnitude of oil-specific risk to which the oil
industry itself is exposed. An analysis of oil factor loadings and oil risk premia
for individual industry and oil-related subindustry portfolios can be found in
the Internet Appendix.
C.1. Relationship to Macroeconomic Variables

Panel A in Table IV reports contemporaneous correlations between vari-
ous macroeconomic variables and the model-extracted oil factor excess returns
between 1983 and 2012. At every date, the estimation procedure produces a
e
distribution for the Ri,t ’s and we use the mean of that distribution to calculate
correlations or regression results.15 We include the short rate (three-month
constant-maturity Treasury rate), term premium (spread between Treasury
10-year and three-month rates), default premium (spread between Moody’s
overfitting to the implied variance, boosting the R2 from 98% to essentially one, the bv ’s remain
negative though marginally significant.
14 While there is much concentration in the oil industry, mostly among nationally owned com-
panies in oil producing nations, our focus is on publicly traded international oil companies (IOCs),
which arguably face a more competitive landscape. Since the OPEC price wars of 1986, in addition
to competing with each other, IOCs also face curtailed profits from production and investment
because of governments in consumer countries who appropriate surpluses through taxes (see Bad-
dour (1997)).
15 The VIX data are from the Chicago Board Options Exchange: http://www.cboe.com/
micro/vix/historical.aspx. We use VOX for the pre-1990 period, for which CBOE does not use
the new method to calculate VIX. The other macroeconomic data are from the St. Louis Fed:
http://research.stlouisfed.org/fred2/.
Table IV
Relationship to Macroeconomic Variables
Panel A reports the correlations, in percentages, between model-extracted oil factor excess returns
and macroeconomic variables. Panel B reports regression coefficients of regressions of macroe-
conomic variables on contemporaneous oil factor excess returns, and the adjusted-R2 ’s of the
regressions. Panel C reports regression coefficients of predictive regressions of macroeconomic
variables on their own lags and lagged oil factor excess returns, and the adjusted-R2 ’s of the
predictive regressions. All regression coefficients are multiplied by 100, and all adjusted-R2 ’s are
reported in percentages. “*” (“**”) indicates significance at the 5% (1%) level. Significance is based
on Newey-West standard errors with 10 lags.
Panel A: Contemporaneous Correlations; In Percentages
Short Term Default (VIX2 ) Inflation Ind. Prod. Unemploy- GDP

Factor Rate Premium Premium Growth ment Growth
Rse −0.4 −0.3 −15.4 −12.0 24.3** 1.0 −16.0 14.3

Rle −15.3 −2.3 5.6 −18.0 −3.6 1.9 −6.4 −7.7
Rep 6.7 3.4 −9.2 6.3 16.0 −7.9 4.7 6.9
Rve −13.7 −1.8 54.1** 16.7 −31.7** −4.7 37.4** −39.8**
Panel B: Contemporaneous Regressions; Coefficients × 100
Variable Constant Rse Rle Rep Rve Adj R2 (%)
Short Rate 4.1** −0.6 −5.2** −5.3** −2.2* 4.9

Term Premium 1.7** 0.1 0.2 0.3 0.0 −3.7
Default Premium 1.0** 0.1 0.2 0.2 1.0** 26.9
(VIX2 ) 0.4 −0.9 −9.3** −9.5* 2.2 7.1
Inflation −0.6* 8.1** 7.8** 13.8** −2.5 19.3
Ind. Prod. Growth 0.0 −2.9 −7.4* −11.3* −3.3* −0.1
Unemp. Rate 0.0 0.0 0.1 0.2 0.6** 12.0
GDP Growth 2.9** 0.4 −2.6* −2.5 −4.6** 14.4
Panel C: Predictive Regressions at One Quarter Lag; Coefficients × 100
Variable Constant Rse Rle Rep Rve Own Lag Adj R2 (%)
Short Rate 0.0 −0.2 0.1 0.1 −0.2 −1.9 −3.3

Term Premium 0.2* −0.4 0.2 0.3 0.1 −10.7** 3.1
Default Premium 0.3* −0.1 −0.1 −0.1 0.2 −26.3** 8.8
(VIX2 ) −0.1 −0.2 2.8 1.4 0.3 −35.4** 11.6
Inflation −0.1 −1.6 0.7 0.3 1.8 −41.8* 19.0
Ind. Prod. Growth 0.1 −2.4 −8.9 −14.7 −11.3** 17.2 18.3
Unemp. Rate 0.0 0.1 0.2 0.2 0.4** 46.8** 33.5
GDP Growth 1.6** −2.0* −1.7 −3.3 −2.9** 43.3** 28.8
Baa and Aaa rates), change in squared VIX (squares and differences are
e
taken for better comparison with Rv,t ), change in inflation (growth rate of
CPI), real growth of industrial production, change in unemployment, and real
GDP growth. All macroeconomic variable data are annualized quarterly time
series.16 The daily factor excess returns are correspondingly compounded to

e
produce quarterly time series. Of the four risk factors, implied oil variance, Rv,t ,
appears most related to macroeconomic variables, exhibiting significant corre-
lations with default spreads, inflation changes, changes in unemployment, and
GDP growth. Other than inflation, the signs of these correlations indicate that
increases in Xv,t are linked to negative economic outcomes. The other oil factors
are more weakly related to macroeconomic variables. In particular, while the
third persistent factor is associated with a significant risk premium, it does
not appear to be significantly related to any contemporaneous variable in the
panel. On the other hand, one expects economic variables with oil sensitivity to
be simultaneously related to a combination of the factors, which suggests that
univariate correlations might not capture the extent of dependence on oil risk.
Pursuing this further, Panel B of Table IV documents the results of con-
temporaneous multivariate regressions of the macrovariables on the oil risk
factors. Several results stand out. First, the regressions confirm that key eco-
nomic indicators have exposure to oil risk. Nearly half of the coefficients are
significant at the 5% level or better. In particular, the volatility factor, which
appears significant in five of the eight regressions, is unambiguously associ-
ated with bad news for the economy. This might be the reason that even oil
companies’ returns react negatively to increases in Xv,t : if competition in the
oil industry dilutes the value of real options, then the industry’s procyclical-
ity can result in a negative sensitivity to volatility. One can also see that the
long-term and persistent factors are significantly linked to the macroeconomy,
and especially market uncertainty (the VIX) and inflation. Finally, the vary-
ing sensitivities exhibited by the macrovariables to the four oil factors justify
decomposing oil shocks into their various components and suggest a path for
clarifying ambiguous relationships found in previous studies (see Barsky and
Kilian (2004)).
Turning to the predictive regressions (at one-quarter lag) in Panel C, it ap-
pears that by and large only Xv,t is important in forecasting the various tested
variables beyond the influence of the lagged macro variable itself.17 That said,
the economic significance of the predictability is impressive. A one (uncondi-
e
tional) standard deviation increase in Rv,t roughly predicts a 0.67% decline in
annualized real GDP and a 1.7% decline in the growth of industrial production.
Moreover, the 29% adjusted-R2 in the GDP predictive regression suggests that
e
Rv,t compares well with other forecasters of real GDP growth at this horizon
(e.g., see Ang, Piazzesi, and Wei (2006)). The highly significant predictive power
e
of Rv,t for GDP growth, unemployment rate, and industrial production growth
16 Although some of the macrovariables are available at higher frequencies, we use quarterly
series to better compare the forecasting power of the oil risk factors across the macro variables.
17 We include the lagged macroeconomic variable in the predictive regressions as a regressor to
control for the possibility that xt−1 predicts yt only because yt−1 predicts yt and xt−1 happens to
be correlated with yt−1 . For highly persistent interest rate variables (short rate, term premium,
and default premium), we use first differences (yt ) in the left-hand side, and levels (yt−1 ) in the
right-hand side.
suggests that oil volatility shocks are not mere proxies for a business cycle
factor.
C.2. Oil Risk in Nonoil Stocks

FFC Factors: Panel A of Table V reports regressions of the oil factor
excess returns on the FFC four-factor model. It is noteworthy that all four oil
factors exhibit significant loadings, although only the short-term and volatil-
ity factors feature substantial R2 ’s. Most impressive is the fact that the single
highest loading is that of the volatility factor on the HML portfolio (−0.910,
with a t-ratio of −22.6), tying the oil volatility factor to the value premium.18 It
also appears that the risk premium for the volatility factor is explained by its
relationship with the FFC factors. This contrasts with the persistent oil risk
factor, which has only a weak relationship with the FFC factors but exhibits
a significant daily α of 0.055% (t-statistic of 2.31) amounting to about 14%
per annum, leaving us without a clear explanation of the source of the risk
premium for Rep,t .
Panel B of Table V documents coefficients from regressing market returns
on the oil risk factors, as well as regressing the Fama-French oil industry
returns and FFC factor returns on the oil factor and market returns. Oil risk
is not strongly related to aggregate stock market risk, evidenced by the 4.3%
adjusted-R2 in the market regression. Each FFC model factor has significant
though modest exposure to at least three oil risk factors (net of the market).
The partial-R2 statistic measures the variation explained by oil risk net of the
market, and is calculated as the difference between the adjusted-R2 using all
five regressors and the adjusted-R2 regressing only on market returns. Here
we see that the oil factors capture a nontrivial amount of variation in HML
and SMB (and more so than the market), potentially because of their link to
business cycle indicators (Liew and Vassalou (2000) and Petkova and Zhang
(2005)).19 The partial-R2 for oil industry equity returns is comparable to that
of the oil equity portfolios used in the estimation (see Table I).
The exposure of the FFC portfolios to oil risk factors can be measured relative
to that of the oil industry. For i = s, l, p, or v, and any asset excess return
denoted by rz , define
bz,i
βi (rz ) ≡ , (11)
|boil ind,i |
where bz,i is the regression coefficient obtained by regressing rz on the market
and oil factor returns as in equation (10), while boil ind,i similarly corresponds
to the regression coefficient for oil industry excess returns. In other words,
18 The relationship between Re and HML is unlikely to come from having used B/M-sorted oil
v,t
equity portfolios in our estimation. A portfolio that is long high-B/M oil stocks and short low-B/M
oil stocks has a correlation coefficient of 0.066 with the standard HML factor.
19 Among SMB, HML, and UMD, the average adjusted-R2 (not reported in the table) is 7.3%
with HML having the largest R2 at 14.0% and UMD the smallest at 4.2%.
Table V
Relationship between Fama-French-Carhart and Oil Factors
Panel A reports the coefficients from regressing each oil factor excess return on the Fama-French-Carhart (FFC) factors (SMB, HML, and UMD) and
the market’s excess return (EMKT). Panel B reports the coefficients from regressing each of the FFC factors on the oil factors and market excess
returns. Results of a regression of the market on the oil factor excess returns are also reported. Partial Oil R2 is the difference between the regression
adjusted-R2 and the adjusted-R2 from a regression employing only market excess returns as a regressor. The oil β’s, β j are the regression coefficients
normalized so that the Fama-French oil industry (“FF oil ind”) is defined to have (βs , βl , β p , βv ) = (1, 1, 1, −1). Means and confidence intervals for
the annualized net oil risk premia (reported in the last column) are calculated using the posterior distribution of oil risk premia estimated from the
model. “* ” (“** ”) indicates significance at the 5% (1%) level.
Panel A: Oil Factor Decomposition
Dependent Variable EMKT SMB HML UMD α (%) Adj R2
Rse 0.12** 0.39** 0.44** 0.02 −0.010 7.8

Rle 0.05* 0.27** 0.32** 0.14** −0.006 1.1
Rep 0.13** −0.18** 0.03 −0.05 0.055* 0.9
Rve −0.47** −0.58** −0.91** 0.02 0.011 12.6
Panel B: FFC Factor Decomposition
Dependent Partial Oil Net Oil

Variable bM bs bl bp bv R2 (%) βs βl βp βv RP (%)
EMKT NA 0.03** 0.01 0.05** −0.11** NA NA NA NA NA NA

FF oil ind 0.76** 0.45** 0.07** 0.17** −0.21** 23.6 1 1 1 −1 5.34**
SMB −0.09** 0.08** 0.02** 0.00 −0.04** 4.9 0.19 0.21 0.00 −0.18 0.40
HML −0.14** 0.09** 0.03** 0.03** −0.06** 8.8 0.20 0.36 0.15 −0.28 1.05*
UMD −0.12** −0.03** 0.01* 0.00 0.03** 0.9 −0.07 0.20 0.00 0.16 −0.32
Estimating Oil Risk Factors from Equity and Derivatives Markets
789
βi (rz ) measures the sensitivity of a portfolio’s returns to oil risk relative to that
of oil industry stocks. Columns 8 to 11 of Panel B, Table V, report the oil β’s
for the SMB, HML, and UMD portfolios. Their magnitude averages to 0.17,
corresponding to about a sixth of the exposure of the oil industry. Placing this
into perspective, the weight of the oil industry portfolio in the market portfolio
is roughly 3.1% throughout our sample period. This supports the notion that
oil risk impacts the economy far beyond oil-related firms.
In the last column of Panel B, Table V, we calculate the unconditional net
oil risk premium for each of the portfolios. This is done using the posterior dis-
tribution of parameters and latent factors produced by the MCMC estimation.
Specifically, we simulate the parameters and Xi,t ’s from the posterior distribu-
tion, regress the FFC and oil industry returns on each corresponding instance
e
of the Ri,t ’s and the market excess return, randomly draw the normally dis-
tributed regression coefficients, and multiply the drawn oil factor regression
coefficients by that simulation’s ¯ to produce a possible realization of the risk
premium that incorporates both model estimation and sample estimation er-
rors. This generates a distribution of risk premia for each portfolio. The table
reports the mean of the distribution and indicates whether it is significantly
different from zero. About a sixth of the risk premia of SMB and HML ap-
pears to be captured by their oil risk exposures. This is consistent with an APT
structure spanned by five to seven fundamental risk factors of which oil is but
one.
Characteristic Portfolios: In Table VI we repeat the exercise of calculating
oil risk β’s (net of the market) and net oil premia for the 25 size-B/M and the
25 size-momentum portfolios from Kenneth French’s data library.20 The oil β’s
documented in Panel B of Table V are reflected in the cross-sectional variation
across the sorted portfolios. Smaller firms (value firms) tend to have a larger
magnitude of exposure than larger firms (growth firms). Recent “winners” have
less negative exposure to oil volatility and more positive exposure to long-term
oil risk than recent losers. All but 3 of the 50 portfolios have negative and
significant exposure to the volatility factor. The average magnitude of exposure
across all 50 portfolios is 20% that of the oil industry, confirming that oil risk
plays a modest but economically significant role in the economy.
As in Table V, the net oil risk premium for each portfolio is calculated at the
bottom (significant premia are in bold to make any pattern easier to identify).
The average magnitude of net oil risk premium across the portfolios is 0.70%
per annum which, while small, is consistent with the hypothesis that oil risk
is one of a handful of key systematic risk factors in the economy. Note that it
is typically larger-firm portfolios that feature significant risk premia despite
20 The two sets of portfolios are constructed differently. The size-B/M portfolios are rebalanced
once per year, while the size-momentum portfolios are constructed daily. This leads to small dif-
ferences in the regression results when aggregating across the B/M and momentum quintiles. In
addition, aggregating over all 25 size-B/M (or size-momentum) portfolios does not result in the
market portfolio that we employ, and when regressed against the market and the oil factors yields
a regression coefficient of 0.89 on the market along with highly significant (albeit small) oil factor
coefficients.
Table VI
β’s and Annualized Percentage Risk Premia for Each Size-Characteristic Sorted Portfolio
The characteristics used are book value (“Book”) and momentum (“Mom”), and the data are taken from Kenneth French’s website. The full-sample
returns on each portfolio are regressed against the excess oil returns and the market to calculate oil β’s, β j . The β j ’s are normalized so that the
Fama-French oil industry is defined to have (βs , βl , β p , βv ) = (1, 1, 1, −1). Means and confidence intervals for the net oil risk premia (reported in the
bottom panel) are calculated using the posterior distribution of oil risk premia estimated from the model. “*” (“**”) indicates significance at the 5%
(1%) level.
Size Size
Book 1 2 3 4 5 Mom 1 2 3 4 5
βs 1 0.25** 0.15** 0.08** −0.01 −0.19** 1 0.35** 0.29** 0.27** 0.23** 0.06*
2 0.25** 0.22** 0.16** 0.16** −0.01 2 0.31** 0.25** 0.20** 0.16** 0.00
3 0.25** 0.27** 0.23** 0.23** 0.12** 3 0.28** 0.24** 0.21** 0.15** 0.00
4 0.27** 0.24** 0.24** 0.24** 0.07** 4 0.28** 0.26** 0.20** 0.15** −0.02
5 0.30** 0.31** 0.21** 0.18** 0.09** 5 0.29** 0.25** 0.22** 0.15** −0.02
βl 1 0.20** 0.10 0.00 −0.10 −0.22** 1 0.30** 0.16 0.02 0.16 −0.06
2 0.24** 0.24** 0.19** 0.19** −0.03 2 0.35** 0.27** 0.21** 0.06 −0.07
3 0.33** 0.36** 0.39** 0.30** 0.17** 3 0.35** 0.37** 0.30** 0.14** 0.00
4 0.36** 0.37** 0.43** 0.31** 0.10 4 0.38** 0.36** 0.31** 0.23** 0.08
5 0.40** 0.50** 0.33** 0.27** 0.29** 5 0.47** 0.42** 0.35** 0.31** 0.20**
βp 1 0.01 −0.05 −0.02 −0.03 −0.12** 1 0.05 0.04 0.07 0.13** 0.10*
2 0.01 0.00 0.01 0.05** −0.01 2 0.06* 0.03 0.06* 0.02 −0.03
3 0.04 0.04 0.09** 0.12** 0.07** 3 0.05* 0.06* 0.07** 0.03* 0.00
4 0.06* 0.06* 0.11** 0.13** 0.07** 4 0.07** 0.03 0.05** 0.05** 0.00
5 0.09** 0.07* 0.07** 0.06* 0.09** 5 0.09** 0.05 0.08** 0.10** 0.05*
βv 1 −0.32** −0.13** −0.05** 0.08** 0.19** 1 −0.49** −0.39** −0.30** −0.24** −0.24**
2 −0.33** −0.25** −0.15** −0.21** −0.04** 2 −0.48** −0.38** −0.33** −0.30** −0.09**
3 −0.35** −0.29** −0.25** −0.32** −0.15** 3 −0.43** −0.35** −0.30** −0.26** −0.11**
4 −0.34** −0.33** −0.34** −0.33** −0.21** 4 −0.39** −0.32** −0.25** −0.19** −0.03**
5 −0.39** −0.36** −0.25** −0.30** −0.14** 5 −0.34** −0.28** −0.18** −0.09** 0.11**
1 0.70 0.10 0.05 −0.24* −0.80* 1 1.16 0.92 0.85 0.93* 0.77**
Estimating Oil Risk Factors from Equity and Derivatives Markets
Net Oil 2 0.71 0.52 0.37 0.59 0.03 2 1.17 0.89 0.85 0.67 0.08
RP (%) 3 0.85 0.76 0.81 1.04* 0.53* 3 1.04 0.89 0.84 0.63 0.21
4 0.89 0.86 1.05 1.09* 0.60* 4 1.01 0.77 0.69 0.57 0.06
791
5 1.10 0.99 0.73 0.81 0.57 5 1.00 0.75 0.66 0.53 −0.06
having generally lower exposure to oil risk. This is because the larger-firm
portfolios are less volatile and their factor loadings can be determined more
accurately.
The greatest cross-sectional variation in oil factor loadings is between the
size=1 & B/M=5 portfolio and the size=5 & B/M=1 portfolio—among the 25,
it is also these two portfolios that exhibit the highest cross-sectional disper-
sion in expected return. A portfolio long on the former and short on the
latter has an average oil β that is about one-half of that of the oil indus-
try and a net oil risk premium of 1.90%. The size=5 & B/M=1 portfolio
is particularly interesting in that it appears to act as a hedge against oil
risk.
Industry Portfolios: The preceding analysis confirms that our extracted oil
factors are systematic and that portfolios formed on financial characteristics
vary cross-sectionally with respect to oil risk. In particular, firms whose finan-
cial characteristics make them particularly sensitive to business cycle vari-
ables appear to have greater net exposure to oil risk. Next we examine a
different cross-sectional property: industry. The FFC model is not generally
as useful when applied to industry portfolios, possibly because industry port-
folio returns do not vary enough across size and B/M. One does intuitively
expect, however, that some industries will have significantly higher sensitivity
to oil risk than others. To test this intuition, we use the 49 industry returns
collected by Kenneth French and posted on his website, and remove the oil
industry portfolio used earlier in Panel B of Table V. Each day for each indus-
try, starting on June 24, 1983, and ending on December 31, 2012, we regress
the past 60 trading days of industry excess returns on the market excess re-
e
turn and the Ri,t ’s (also from the past 60 trading days). On a daily basis, we
then sort the 48 industry portfolios based on the regression coefficient of Rie
(we do this separately for i = s, l, p, and v). Next, we form eight “octile” port-
folios out of that day’s loading-sorted industry returns (e.g., the lowest octile
equally weights the returns of the six industries with the lowest regression
coefficient). Altogether, we construct 8 × 4 portfolios: eight octiles rebalanced
daily and based on the regression coefficient with respect to each of the four
factors.
If there is no cross-sectional variation in net oil risk exposure across in-
dustries, then each industry would be represented equally in each octile and
appear with frequency 2.08%. Table VII documents the five highest-frequency
industries in the first and last octiles across all days. A clear pattern emerges:
precious metals, mining, and coal consistently appear in octile 8 for Rse , Rle ,
and Rep, and correspondingly in octile 1 for Rve (recall that exposure to Rve is
generally negative for firms that are positively exposed to the other oil fac-
tors). Similarly, construction appears three times and steel twice in these
same octiles. Thus, the industries with the highest oil sensitivity are com-
modities and basic manufacturing. The least oil-sensitive industries appear-
ing consistently (in octile 1 for Rse , Rle , and Rep, and in octile 8 for Rve ) are
tobacco products, candy and soda, computer hardware, defense, and electronic
equipment.
Table VII
Industries Most Frequently Represented in the Top and Bottom
Octiles, Sorted Based on Exposure to the Oil Factors
Each day, the excess returns of each of the 48 nonoil industries based on the classification in
Kenneth French’s website are regressed on the four oil factors’ excess returns and the market,
using the previous 60 trading days’ returns. The 48 industries can then be sorted into eight octiles
e
according to the regression coefficient on Ri,t : the six industries with the highest (lowest) recent
e
past sensitivity to Ri,t are equally weighted at date t for the purpose of calculating the date t return
of the eighth (first) octile sorted by sensitivity to Xi .
Panel A: Frequencies in the Top and Bottom Octiles

Sorting by Sensitivity to
Xs Xl Xp Xv
Industry Freq (%) Industry Freq (%) Industry Freq (%) Industry Freq (%)
Octile 1 Smoke 5.02 Gold 4.56 Smoke 3.91 Coal 8.76

Beer 4.22 Soda 4.49 Agric 3.48 Gold 8.16
Hardw 4.19 Smoke 4.38 Guns 3.44 Mines 6.17
Soda 4.17 Hardw 3.82 Autos 3.3 Steel 5.22
Guns 3.73 Chips 3.48 Soda 3.26 Cnstr 4.98
Octile 8 Gold 10.9 Coal 6.39 Gold 10.15 Hardw 5.61
Coal 9.6 Gold 6.25 Coal 8.22 Softw 4.61
Mines 8.19 FabPr 4.46 Mines 6.34 Soda 4.54
Cnstr 5.35 Mines 4.24 Cnstr 5.06 Chips 4.08
Steel 5.19 Ships 3.85 Agric 3.81 Smoke 3.98
Panel B: Industry Abbreviations
Short Name Industry
Agric Agriculture
Autos Automobiles and Trucks
Beer Beer & Liquor
Soda Candy & Soda
Coal Coal
Softw Computer Software
Hardw Computers
Cnstr Construction
Guns Defense
Chips Electronic Equipment
FabPr Fabricated Products
Mines Nonmetallic and Industrial Metal Mining
Gold Precious Metals
Ships Shipbuilding, Railroad Equipment
Steel Steel Works Etc
Smoke Tobacco Products
Table VIII
794
β’s and Annualized Percentage Risk Premia for Industries Sorted on Sensitivity to Oil Factors
Each day, the excess returns of each of the 48 nonoil industries based on the classification in Kenneth French’s website are regressed on the four oil
factors’ excess returns and the market, using the previous 60 trading days’ returns. The 48 industries can then be sorted into eight octiles according
e
to the regression coefficient on Ri,t : the six industries in each octile are equally weighted at date t for the purpose of calculating the date t return of
the eighth (first) octile sorted by sensitivity to Xi . This is done daily for each of the Xi ’s to produce 32 octile portfolios. The full-sample returns on
each octile portfolio are then regressed against the excess oil returns and the market to calculate oil β’s, β j . To facilitate comparison, we normalize
the β j ’s so that the Fama-French oil industry is defined to have (βs , βl , β p , βv ) = (1, 1, 1, −1). Means and confidence intervals for the net oil risk
premia (reported in the bottom panel) are calculated using the posterior distribution of oil risk premia estimated from the model. “*” (“**”) indicates
significance at the 5% (1%) level.
Sorted by Sensitivity Octile
Sensitivity to 1 2 3 4 5 6 7 8 8 minus 1
βs Xs −0.07** −0.02* −0.01 0.00 0.06** 0.08** 0.17** 0.57** 0.65**

Xl 0.03 0.02 0.04** 0.02 0.04** 0.08** 0.17** 0.39** 0.37**
Xp 0.01 0.00 0.02* 0.04** 0.05** 0.09** 0.12** 0.45** 0.45**
Xv 0.51** 0.18** 0.10** 0.07** 0.04** −0.02* −0.04** −0.06** −0.57**
βl Xs −0.04 0.06 0.03 0.07 0.07 0.17** 0.27** 0.75** 0.79**
Xl 0.00 0.08 0.03 0.11* 0.11* 0.11* 0.29** 0.64** 0.64**
Xp 0.16** 0.00 0.11* 0.10* 0.02 0.17** 0.19** 0.62** 0.46**
Xv 0.66** 0.27** 0.26** 0.15** 0.12** −0.01 0.06 −0.13* −0.80**
The Journal of FinanceR
βp Xs −0.10** −0.08** −0.10** −0.06** −0.06** −0.01 0.08** 0.47** 0.58**

Xl −0.01 −0.05** −0.05** −0.04* −0.07** −0.04* 0.09** 0.33** 0.35**
Xp −0.03 −0.08** −0.06** −0.09** −0.07** 0.00 0.06** 0.42** 0.46**
Xv 0.41** 0.07** 0.00 −0.04* −0.04* −0.12** −0.07** −0.08** −0.49**
βv Xs 0.05** 0.02 −0.07** −0.09** −0.12** −0.18** −0.29** −0.63** −0.68**
Xl 0.00 −0.04** −0.09** −0.12** −0.11** −0.19** −0.26** −0.48** −0.48**
Xp −0.02 −0.03** −0.10** −0.11** −0.15** −0.18** −0.19** −0.51** −0.50**
Xv −0.65** −0.33** −0.18** −0.13** −0.07** −0.05** 0.02 0.08** 0.73**
Net Oil Xs −0.47** −0.29* −0.21 −0.03 0.03 0.31 0.82* 2.84* 3.29**
RP (%) Xl −0.05 −0.10 0.00 0.09 −0.02 0.22 0.80* 2.06* 2.11*
Xp −0.08 −0.21 −0.02 −0.09 0.05 0.35 0.57* 2.44** 2.52**
Xv 2.66* 0.86 0.37 0.12 0.00 −0.32* −0.27** −0.42* −3.09**
Table VIII reports the net oil β’s and risk premia of the 32 sensitivity-sorted
portfolios. The table confirms that sorting based on the sensitivity of one factor
is highly correlated with sorting based on another factor (negatively correlated,
when sorting on Rve sensitivity). In other words, most firms that are highly
sensitive to one risk factor tend to also be proportionately sensitive to the
others. Moreover, only the top two octiles (bottom two octiles when sorting on
Rve sensitivity) admit a high magnitude of sensitivity to the oil factors. Thus, in
practice, about 25% of industries are substantially affected by oil risk, although
which industries are affected can vary over time. In both Tables VI and VIII,
the preponderance of positive β’s with respect to the first three factors and
negative β’s for the volatility factor suggest that relatively few stocks can be
used to hedge the oil risk factors. Thus, because oil risk is hard to hedge or
diversify away completely, it should be priced. Indeed, the average magnitude
of the β’s is 14.3% while the average magnitude of risk premium is 0.70%.
Averaging the magnitude of exposures of the 32 industry octile portfolios and
the 50 characteristic portfolios from Table VI yields an average magnitude of
exposure that is roughly one-sixth of that of the oil industry. Finally, despite
the fact that only nonoil industries are used to construct the octile portfolios,
a portfolio long octile 8 and short octile 1 (the “8 minus 1” column) will have
oil β’s that are roughly two-thirds the magnitude of the oil industry and a
commensurately high net oil risk premium. Moreover, while each of the “8
minus 1” portfolio risk premia are significant at the 1% level, the hypothesis
that all four have a net oil risk premium of zero can be rejected at the 0.1%
level (accounting for their correlations), consistent with the more demanding
threshold in Harvey, Liu, and Zhu (2013).
In the Internet Appendix we report individual industry and oil subindus-
try loadings and risk premia. Sixteen out of 49 exhibit significant risk
premia with commodity-linked industries having the largest positive risk pre-
mia while retail, technology, and pharmaceuticals have the most negative.
Among oil subindustries, airlines have a large and negative exposure with
a net oil risk premium of −4.88% coming mostly from the persistent fac-
tor. Oil equipment and services is the most sensitive subindustry with 1.80
times the volatility exposure of the oil industry and a net oil risk premium
of 8.24%.
C.3. Oil Risk Information in Oil Stocks

Do the factors explain as much of the cross-section when they are estimated
using derivative prices only (“DO oil factors”)? When applying the analysis in
this section to DO factors we find that none of the 139 portfolios examined in
Tables V, VI, and VIII exhibit risk premia that are significant at the 1% level
(eight are significant at the 5% level). This is despite the fact that the fac-
tors do exhibit strong evidence of priced (and therefore systematic) risk. Thus,
the equities used in the estimation are crucial in capturing the covariation of
stocks with oil risk. By contrast, Table IV when constructed using the DO oil
factors produces results that are qualitatively similar to what is obtained with
the FI estimation of the factors. Indeed, what seems to be going on is that

the DO and FI oil factor return estimates are poorly correlated at daily fre-
quencies but highly correlated at quarterly frequencies. Thus, equities contain
high-frequency information about the factors. This can be because daily deriva-
tive price fluctuations are noisy—whether because of modeling error (we are
not incorporating embedded timing options) or because of short-term market
segmentation (the two markets are linked but short-term deviations between
them are hard to arbitrage away).
IV. Conclusion
We study the implications of commodity derivative models for equity mar-
kets. We do this by including oil equity returns in the estimation of a structural
model of the term structure of oil futures with unspanned volatility. The esti-
mation technique delivers a time series for four oil risk factors, corresponding
to shocks influencing oil prices in the short-term, in the long-term, persistently,
or through volatility shocks. Our fit to derivative prices is excellent and robust,
and the risk factors we identify appear to be associated with a significant risk
premium. When information from oil-sensitive equities is incorporated into the
estimation of the oil factors, their ability to explain oil-related stock returns
drastically improves (the R2 increases by an average of roughly 20%) while the
fit to derivatives prices remains largely unchanged. Moreover, the additional
information from equities is crucial in allowing us to better estimate the oil
factor risk premia.
The extracted oil risk factors, and in particular the one corresponding to un-
spanned volatility, appear to be systematic. Oil volatility exhibits an econom-
ically and statistically significant negative relationship with growth variables
such as real GDP and industrial production, and a positive relationship with
negative indicators such as the VIX index and unemployment. The magnitude
of oil risk exposure for an average nonoil firm is between 14% and 20% of the
oil risk exposure for the oil industry itself, and corresponds to an average risk
premium magnitude of 0.70%.
Overall, our results provide evidence that oil risk (or alternatively, energy
risk), adequately filtered from noisy price data, is one of a handful of fundamen-
tal factors that affect the pricing of both oil and nonoil securities. In principle,
our methodology could be applied to extracting other fundamental risk factors,
paving the way for a more structured approach to the pricing of securities in
an APT framework.21
Initial submission: May 14, 2012; Final version received: July 10, 2014
Editor: Campbell Harvey
21 Because similar issues have been raised in the literature on currency risk (e.g., Dumas and
Solnik (1995) and Campbell, Serfaty-de Medeiros, and Viceira (2010)), this might be a natural
candidate for an exploration using our method.
Appendix A: The General A1 (4) Model

The most general affine four-factor model with one stochastic volatility
factor has a risk-neutral evolution of the spot price process S of the form
log St = a + b Yt , (A1)
where Yt ∈ R4 has affine drift and instantaneous variance:
dYt = (A∗ + B∗ Yt )dt + t dWt∗ , (A2)
t t = 0 + 1 × c Yt . (A3)
The total number of parameters is 48: one in a, four in b, four in A∗ , 16 in B∗ ,

10 in 0 , 10 in 1 , and, because c is defined only up to a scalar multiple, three
in c. However, these parameters are not all well defined because there is am-
biguity in the choice of state variable Y : any invertible affine transformation
Xt = ψ + Yt , where ψ is a four-vector and is an invertible 4 × 4 matrix, will
also have affine dynamics as in equations (A1) to (A3). The group of symmetries
of the set of state variables with A1 (4) dynamics is therefore 20-dimensional;
intuitively, this represents 20 degrees of ambiguity in the choice of state vari-
able Y , or equivalently, 20 degrees of ambiguity in the choice of parameter set
= (a, b, A∗ , B∗ , 0 , 1 , c), and therefore the identifiable model should have at
most 28 = 48 − 20 free parameters.
Without loss of generality, it may always be assumed that Y1,t = log St and
Y4,t = Vt , the (squared) volatility of St , by first replacing a + bYt with Y1,t and
then replacing (0 )1,1 + (1 )1,1 c Yt with Y4,t . After this substitution is made,
the risk-neutral drift of Y1,t may be replaced by Y2,t − 12 Y4,t , and then the risk-
neutral drift of Y2,t may be replaced by Y3,t . With this identification, there is
no more ambiguity in the choice of state variable; the group of symmetries now
consists of only the trivial transformation ψ = 0 and = I, the identity matrix.
Therefore, given the most general affine model satisfying equations (A1)
to (A3), there exists a unique invertible affine transformation of the state
vector for which Y1,t is the log spot price, Y4,t is the spot price volatility,
t t = 0 + 1 Y4,t , and
⎡ ⎤ ⎡ ⎤
0 0 1 0 − 12
⎢0⎥ ⎢ 0 0 1 0 ⎥
A∗ = ⎢ ⎥
⎣ u1 ⎦ , B∗ = ⎢ ⎥
⎣ k31 k32 k33 k34 ⎦ .
u2 k41 k42 k43 k44
A quick count reveals there are indeed 28 free parameters (two in A∗ , eight in
B∗ , and nine in each of 0 and 1 since 0 (1, 1) = 0 and 1 (1, 1) = 1), but ad-
missibility will impose restrictions on some of these parameters. In particular,
the drift of the volatility Y4,t must be nonnegative for the volatility to remain
positive, and therefore k41 = k42 = k43 = 0. In addition, when the volatility state
variable Y4,t approaches zero, its instantaneous variance and covariance with
the other state variables must vanish, otherwise the volatility would drop be-
low zero with positive probability, and therefore the fourth row and column of
0 are zero.
For the purposes of this study, it is more convenient to consider the equivalent
representation
log St = X1,t + X3,t ,

∗ ∗ ∗
dXt = (A
⎡ +⎤B Xt )dt + ⎡ t dWt , ⎤
0 −κ1 0 0 κ5
⎢ μ ⎥ ⎢ 0 −κ2 κ4 κ1 κ5 ⎥
A∗ = ⎢ 1⎥
⎣ 0 ⎦, B∗ = ⎢
⎣ 0 1
⎥,
0 − 12 − κ5 ⎦
μ2 0 0 0 −κ3
t t = 0 + 1 X4,t ,
where X4,t is again the spot price volatility, so that
0 (1, 1) + 20 (1, 3) + 0 (3, 3) = 0

1 (1, 1) + 21 (1, 3) + 1 (3, 3) = 1,
and the fourth row and column of 0 are zero. A straightforward calculation
shows that, given such a state variable X, the state variable given by
⎡ ⎤ ⎡ ⎤
0 1 0 1 0
⎢ 0 ⎥ ⎢ −κ1 1 0 0 ⎥
Yt = ⎢ ⎥ ⎢ ⎥
⎣ μ1 ⎦ + ⎣ κ 2 −κ2 κ4 0 ⎦ Xt
1
0 0 0 0 1
has dynamics congruent with the previous “Y -representation” and therefore

these two representations are equivalent. Further details are given in the In-
ternet Appendix. We now show how unspanned stochastic volatility (USV) and
the presence of a persistent component further constrains the representation.
Appendix B: Futures Prices and USV

Standard arguments from affine term structure models used to price bonds
imply that the log futures price at time t for delivery at time t + τ is given by
log Ft,τ = χ (τ ) + η (τ )Xt ,
where χ and η satisfy the set of differential equations (with respect to τ )

1
χ̇ = η A∗ + η 0 η, (B1)
2
1
η̇ = η B∗ + (0, 0, 0, η 1 η) (B2)
2
with initial values χ (0) = 0 and η(0) = (1, 0, 1, 0).
The model will exhibit USV if and only if the fourth component η4 is identi-
cally zero, which from equation (B2) is equivalent to the condition
1 1
(η1 , η2 , η3 ) · (κ5 , κ1 κ5 , − − κ5 ) + (η1 , η2 , η3 , 0)1 (η1 , η2 , η3 , 0) ≡ 0. (B3)
2 2
In concordance with the premise of this study, we impose the restriction κ4 = 0,

so that the log spot price has a persistent component (given by X3 ).22 It follows
that the first three components of η are given by
1 − e−κ2 τ
η1 (τ ) = e−κ1 τ , η2 (τ ) = , η3 (τ ) = 1;
κ2
substituting into equation (B3) and collecting terms reveals
1 (1, 1) = 1 (1, 2) = 1 (2, 2) = 0, κ1 κ5 + 1 (2, 3) = 0, κ5 + 1 (1, 3) = 0.
To be well defined, the instantaneous variance 0 + 1 X4,t must be positive

definite for all X4,t > 0; it suffices that 0 and 1 are positive semidefinite and
have disjoint null spaces. Because the upper left 2 × 2 submatrix of 1 is zero,
1 will be positive semidefinite if and only if 1 (1, 3) = 1 (2, 3) = 1 (1, 4) =
1 (2, 4) = 0, in which case κ5 = 0 as well. Thus,
⎡ ⎤ ⎡ ⎤ ⎡ ⎤
−κ1 0 0 0 00 0 0 s11 s12 s13 0
⎢ 0 −κ2 0 0 ⎥ ⎢0 0 0 0 ⎥ ⎢ s12 s22 s23 0⎥
B∗ = ⎢
⎣ 0
⎥, 1 = ⎢ ⎥, 0 = ⎢ ⎥,
1 0 − 12 ⎦ ⎣0 0 1 σ14 ⎦ ⎣ s13 s23 s33 0⎦
0 0 0 −κ3 00 σ14 σ44 0 0 0 0
where s11 + 2s13 + s33 = 0. This restriction implies that the characteristic poly-
nomial of 0 has no negative root, that is, 0 is positive semidefinite, if and
only if
⎡ ⎤
s11 s12 −s11 0
⎢ s12 s22 −s12 0⎥
⎢
0 = ⎣ ⎥.
−s11 −s12 s11 0⎦
0 0 0 0
Furthermore, 0 and 1 will have disjoint null spaces if and only if the upper
left 2 × 2 submatrix of 0 is strictly positive definite. See the Internet Appendix
for more details.
22 Many other studies also restrict the risk-neutral “mean reversion” matrix to have a zero
eigenvalue; see Gibson and Schwartz (1990), Schwartz and Smith (2000), and the USV version of
the model in Hughen (2010).
Therefore, the risk-neutral model, with the restriction that κ4 = 0, will be

identifiable and admissible and will exhibit USV if and only if
⎛⎡ ⎤ ⎡ ⎤ ⎞
0 −κ1 0 0 0
⎜⎢ μ1 ⎥ ⎢ 0 −κ2 0 0 ⎥ ⎟
dXt = ⎜ ⎢ ⎥ ⎢ ⎥ ⎟
⎝⎣ 0 ⎦ + ⎣ 0 1 0 − 1 ⎦ Xt ⎠ dt + t dWt
∗
2
μ2 0 0 0 −κ3
t t = 0 + 1 X4,t
⎡ ⎤ ⎡ ⎤
σ12 ρ1 σ1 σ2 −σ12 0 00 0 0
⎢ ρ1 σ1 σ2 σ 2
−ρ1 σ1 σ2 0⎥ ⎢0 0 0 0 ⎥
0 = ⎢ 2
⎣ −σ 2 −ρ1 σ1 σ2
⎥, 1 = ⎢ ⎥
⎣ 0 0 1 ρ2 σ3 ⎦ ,
1 σ12 0⎦
0 0 0 0 0 0 ρ2 σ3 σ32
where −1 < ρ1 , ρ2 < 1, κ1 , κ2 , κ3 , σ1 , σ2 , σ3 > 0, and 2μ2 > σ32 . Trivial relabeling
of the parameters leads to the set of expressions for the model and futures
prices in Section I.
Appendix C: Model-Free Implied Variance

The implied variance
2
T
1 dFs
IVt,T = E∗
T −t t t Fs
is constructed directly from futures option prices following Britten-Jones and

Neuberger (2000) and Jiang and Tian (2005), where T is the maturity date of
the option and the underlying futures contract matures at time T ∗ > T . Due
to the affine structure, the volatility of futures prices is
2
dFs
= η(T ∗ − s)(0 + 1 Xv,s )η(T ∗ − s) ds
Fs
and therefore
T
(T − t) × IVt,T = η(T ∗ − s)0 η(T ∗ − s) ds
t
T
+ η(T ∗ − s)1 η(T ∗ − s) Et∗ [Xv,s ] ds.
t
The first integral is straightforward. The second integral can be computed

by noting that η(T ∗ − s)1 η(T ∗ − s) = 1 and Et∗ [Xv,s ] = e−κv (s−t) Xv,t + μκvv (1 −
e−κv (s−t) ). It follows that the implied variance is of the form
IVt,T = γ (t, T ) + δ(t, T )Xv,t , (C1)

where γ and δ can be found by computing the required integrals:

T
1 μv
γ (t, T ) = η(T ∗ − s)0 η(T ∗ − s) + (1 − e−κv (s−t) ) ds ,
T −t t κv
1
δ(t, T ) = (1 − e−κv (T −t) ).
κv (T − t)
Appendix D: MCMC Estimation

Under our assumptions of admissibility, stationary risk premium, and USV,
the state-space form of the model is
√
Xt+t = At + (I + Bt)Xt + tt εt+t ,
log Ft,τ = χ (τ ) + η(τ ) Xt + ξt,τ ,
IVt,T = γ (t, T ) + δ(t, T )Xv,t + et,T ,

e
rz,t+t = bz,M ReM,t+t + bz,oil (Xt+t − Xt − A∗ t − B∗ tXt ) + z,t+t .
Because the returns in each period are linear functions of the current and
lagged state variables, it is convenient to consider the stacked state vector
Xt
X̃t = [ ], so that the transition and observation equations become
Xt−t

At I + Bt 0 √ t 0
X̃t+t = + X̃t + t ˜ (D1)
0 I 0 0 0 t+t
and
⎡ ⎤ ⎡ ⎤
χt ηt 0
Zt = ⎣ γt ⎦ + ⎣ δ̃t 0 ⎦ X̃t + ξ̃t , (D2)

bM ReM,t − boil A∗ t
boil
−boil (I + B∗ t)
where Zt denotes the vector of stacked log-futures prices, implied variances,

and portfolio returns at time t, χt and γt are the stacked χ (τ ) and γ (t, T )
corresponding to the various futures and implied variance maturities used in
the estimation, ηt is the array of stacked η(τ ) for the various futures maturities,
and δ˜t is the four-column array whose first three columns are zero and whose
fourth column is the stacked δ(t, T ) for the various implied variance maturities.
The stacked state vector is not Gaussian because the volatility state variable
Xv,t appears in the conditional variance matrix; however, as noted in Hughen
(2010) and Collin-Dufresne, Goldstein, and Jones (2009), conditional on Xv the
remaining components of the (stacked) state vector are Gaussian with time-
varying but deterministic variance. Therefore, these remaining components
may be drawn in a single block using, for example, the simulation smoother of
de Jong and Shephard (1995).
The volatility state variable Xv,t is drawn using a separate Metropolis-

Hastings step. By the law of total probability, the conditional density for Xv,t ,
given all other state variables (including the volatility state variable at all other
times), the data (futures, implied variance, and returns), and the parameters,
is proportional to
p (IVt |Xv,t , ) p (rte |Xt , Xt−t , ) p (rt+t

e
|Xt , Xt+t , ) p (Xt+t |Xt , ) p (Xt |Xt−t , ).
The first kernel p(IVt |Xv,t , ) is the (Gaussian) likelihood of the implied vari-
ance data viewed as a function of Xv,t , and the second and third kernels
p(rte |Xt , Xt−t , ) and p(rt+te |Xt , Xt+t , ) are the (Gaussian) likelihoods of the
return data on date t and t + t, viewed as functions of Xv,t , with all other
parameters, the values of the other state variables, and the volatility state
variable at all other times treated as fixed. The fourth and fifth kernels
are the transition densities over the current and previous periods, respec-
tively. As a function of Xv,t the conditional density is not a recognizable
distribution; the volatility state variable Xv,t is drawn using a Metropolis-
Hastings independence sampling algorithm with the Gaussian proposal density
e
p(IVt |Xv,t , ) p(rte |Xt , Xt−t , ) p(rt+t |Xt , Xt+t , ) p(Xt |Xt−t , ). If a negative candi-
date for Xv,t is drawn, it is simply discarded and a new candidate is drawn.
The parameter vector is decomposed into five blocks: 1 = (A, B), 2 =
(μl , μv ), 3 = (κs , κl , κv , σs , σl , σv , ρsl , ρvp), 4 = (bM , boil ), and 5 = W is the vari-
ance matrix of the pricing errors. The first block 1 appears only in the drift
term of the state vector and appears linearly; therefore, its conditional density
is Gaussian and may be drawn in one step from a Gaussian distribution using
the Gibbs sampler. Similarly, because the second block 2 appears linearly in
χt , γt , and the risk-neutral drift terms A∗ and B∗ , it appears linearly in the
observation equation equation (D2) and thus it may also be drawn in a single
step directly from a Gaussian distribution. Similarly, the factor loadings bM
and boil appear linearly in equation (D2) and thus the fourth block 4 may also
be drawn in a single step directly from a Gaussian distribution. The fifth block
5 may also be drawn in a single step. We assume homoskedastic variance of
the futures pricing error, the implied variance error, and the variance of the
idiosyncratic return error. By a standard result, the likelihood function of W
is an Inverse Gamma density function and therefore this block may be drawn
directly using Gibbs sampling.
The third block is more difficult to draw because these parameters appear
nonlinearly in equation (D2). As a result, the conditional density of 3 is not
a recognizable density function. This block is drawn using the relatively inef-
ficient random walk Metropolis-Hastings algorithm with a Gaussian proposal
density.
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Supporting Information
Additional Supporting Information may be found in the online version of this
article at the publisher’s website:
Appendix S1: Internet Appendix

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THE JOURNAL OF FINANCE • VOL. LXX, NO.

Estimating Oil Risk Factors Using Information

the references in Collin-Dufresne, Goldstein, and Jones (2009)). Intuitively, one

where Xt is a four-dimensional state variable and t t is affine in Xt . In

Constraining the risk premium to be stationary restricts the third column

Ft,τ = eχ(τ )+ηs (τ )Xs,t +ηl (τ )Xl,t +η p(τ )Xp,t , (2)

where ηs (τ ) declines with maturity, ηl (τ ) increases with maturity, and η p(τ ) is

where κs is the speed of mean reversion of Xs,t . To interpret this equation,

Instead, we follow the literature on model-free implied variance, on which

IVt,T = γ (t, T ) + δ(t, T )Xv,t . (4)

could construct such “factor-mimicking” portfolios and their instantaneous ex-

IVt,T = γ (t, T ) + δ(t, T )Xv,t + et,T , (9)

II. Data and Empirical Methodology

out-of-the-money contracts.9 Details of the index construction are available in

III. Results and Empirical Analysis

Derivatives Only Full Information FFC

Futures RMSE (basis points) 27.4 28.3 –

in the rate of inflation, industrial production growth, changes in percentage

A.2. Model Stability

B. Oil Risk and Return

Panel A: Subperiod Results

Model Full Information Fama-French-Carhart

Subsample 83-94 94-04 04-13 83-94 94-04 04-13

Panel B: Out-of-Sample Results

1983 to 1994 1994 to 2004 2004 to 2013

83–94 94–04 04–13 83–94 94–04 04–13 83–94 94–04 04–13

Panel A: Statistics of Excess Returns on Oil Factor-Mimicking Portfolios

Sample Mean (%) 0.001 0.004 0.058 −0.016

Panel B: β’s and Net Oil Risk Premia

Asset bM bs bl bp bv Net Oil RP (%)

Small Oil Stocks 0.72∗∗ 0.67∗∗ 0.10∗∗ 0.15∗∗ −0.33∗∗ 6.02*

cross-sectional variation in the expected returns of the basis assets is required

C. Oil Risk beyond the Oil Industry

C.1. Relationship to Macroeconomic Variables

Panel A: Contemporaneous Correlations; In Percentages

Short Term Default (VIX2 ) Inflation Ind. Prod. Unemploy- GDP

Rse −0.4 −0.3 −15.4 −12.0 24.3** 1.0 −16.0 14.3

Panel B: Contemporaneous Regressions; Coefficients × 100

Variable Constant Rse Rle Rep Rve Adj R2 (%)

Short Rate 4.1** −0.6 −5.2** −5.3** −2.2* 4.9

Panel C: Predictive Regressions at One Quarter Lag; Coefficients × 100

Short Rate 0.0 −0.2 0.1 0.1 −0.2 −1.9 −3.3

series.16 The daily factor excess returns are correspondingly compounded to

C.2. Oil Risk in Nonoil Stocks

Panel A: Oil Factor Decomposition

Dependent Variable EMKT SMB HML UMD α (%) Adj R2

Rse 0.12** 0.39** 0.44** 0.02 −0.010 7.8

Panel B: FFC Factor Decomposition

Dependent Partial Oil Net Oil

EMKT NA 0.03** 0.01 0.05** −0.11** NA NA NA NA NA NA

Panel A: Frequencies in the Top and Bottom Octiles

Octile 1 Smoke 5.02 Gold 4.56 Smoke 3.91 Coal 8.76

Panel B: Industry Abbreviations

Short Name Industry

Sorted by Sensitivity Octile

βs Xs −0.07** −0.02* −0.01 0.00 0.06** 0.08** 0.17** 0.57** 0.65**

βp Xs −0.10** −0.08** −0.10** −0.06** −0.06** −0.01 0.08** 0.47** 0.58**

C.3. Oil Risk Information in Oil Stocks

the FI estimation of the factors. Indeed, what seems to be going on is that

Appendix A: The General A1 (4) Model

where Yt ∈ R4 has affine drift and instantaneous variance:

dYt = (A∗ + B∗ Yt )dt + t dWt∗ , (A2)

The total number of parameters is 48: one in a, four in b, four in A∗ , 16 in B∗ ,

log St = X1,t + X3,t ,

Short Rate 4.1 −0.6 −5.2 −5.3** −2.2* 4.9

Rse 0.12 0.39 0.44** 0.02 −0.010 7.8

EMKT NA 0.03 0.01 0.05 −0.11** NA NA NA NA NA NA

βs Xs −0.07** −0.02* −0.01 0.00 0.06 0.08 0.17 0.57 0.65**

βp Xs −0.10 −0.08 −0.10 −0.06 −0.06 −0.01 0.08 0.47 0.58

0 (1, 1) + 20 (1, 3) + 0 (3, 3) = 0

1 (1, 1) = 1 (1, 2) = 1 (2, 2) = 0, κ1 κ5 + 1 (2, 3) = 0, κ5 + 1 (1, 3) = 0.

To be well defined, the instantaneous variance 0 + 1 X4,t must be positive

p (IVt |Xv,t , ) p (rte |Xt , Xt−t , ) p (rt+t